What are Zero Coupon Bonds? Who Should Invest in Them?

Bonds are a fundamental component of the fixed-income investment landscape, representing a loan made by investors to borrowers, typically corporations or government entities. When an issuer needs to raise funds, whether for infrastructure projects, operational costs, or other financial needs, they issue bonds as a means of borrowing. In return, investors receive periodic interest payments, known as coupon payments, along with the principal amount upon maturity. This structure provides investors with a fixed income stream and a defined timeline for return of capital, making bonds an attractive option for those seeking stability and lower risk in their investment portfolios. As a versatile financial instrument, bonds come in various types, each catering to different investment objectives and risk profiles. In this article, we will focus specifically on Zero-Coupon Bonds (ZCB), covering the following topics:

• Meaning of zero-coupon bonds
• Calculation of yield to maturity of ZCB
• Advantages of ZCB
• Risks associated with ZCB
• Taxation Implications

What is a Zero Coupon Bond?

Zero-coupon bonds (ZCB), also known as discount bonds, are issued at a discount on the bond’s face value and do not pay periodic interest to bondholders.

On maturity, the bondholder receives the face value of his investment. In simple words, the investor purchasing a zero coupon bond profits from the difference between the buying price and the face value.  

How to Calculate the Yield to maturity of Zero Coupon Bonds?

Zero coupon bonds can work wonders if used meticulously and in sync with your investment goals. In the absence of any intermittent coupon payments, the yield to maturity(YTM) of a zero coupon bond is calculated as below:

YTM = ((Face value/current market price)^{(1/years to maturity)} ) – 1  

For example: Assume you invest in a 2-year Zero-Coupon bond with a face value of ₹1000 and its current market price being ₹980. In this case, the YTM would be 1.015%. 

Who should invest in Zero Coupon Bonds?

Zero-coupon bonds are a specific kind of financial instrument that might suit investors with particular needs and financial goals. Let’s take a look at some of them:

• Long-Term Investors: These bonds are ideal for those who are not looking for periodic interest payments but are focused on substantial lumpsum payout at a future date.
• Investors with Specific Future Financial Needs: Since Zero Coupon bonds pay the full face value at the maturity date, they are perfect for allocating funds for respective future financial obligations like a child’s education, marriage, retirement etc.
• Risk-Averse Investors: Zero-coupon bonds offer fixed returns if held until maturity and are less risky than equities or variable-rate bonds, so conservative investors can invest in them.   
• Portfolio Diversification: If the investor portfolio primarily consists of growth investments, adding zero-coupon bonds can be advantageous. These bonds can help them secure a guaranteed return over a fixed time period and also help in portfolio diversification.

What are the Advantages of Zero Coupon Bonds?

Zero-Coupon Bonds offer distinctive advantages for certain types of investors. Here are some of the benefits:

• Guaranteed Returns: Zero coupon bonds offer fixed returns if held until maturity. Investors are aware of how much they will receive at the end of the bond’s term, which helps in effective financial planning.
• No Reinvestment Risk: Unlike regular bonds that pay periodic interest, Zero Coupon Bonds eliminate the risk associated with reinvesting interest at potentially lower rates. Since there are no periodic payments, there's no need to worry about finding new investment opportunities for interest income.
• Long-Term Horizon: Zero-coupon bonds are ideal for long-term investors. The fixed amount at a predetermined future date enables long-term financial goals. 

What are the Risks involved with Investing in Zero Coupon Bonds?

Zero Coupon Bonds come with their own set of risks. Here are some of them that you should know before investing:

• Interest Rate Risk: Zero coupon bonds are subject to interest rate risk if sold prior to the date of maturity. The value of these bonds is inversely related to the interest rates. With the rise in interest rates of newer bonds, the demand for older bonds reduces.  
• Duration Risk: Duration risk is the risk associated with a bond’s price sensitivity to a one-percent change in the rate of interest. The sensitivity of long-term zero-coupon bonds to interest rates exposes them to duration risk. This means that the longer a bond’s duration, the greater its sensitivity to interest rate changes. 

Investment Horizon for Zero Coupon Bonds

Long-term zero coupon bonds are generally issued with maturities of 10 to 15 years. There is an inverse relationship between the time and the maturity value of a zero coupon bond. The longer the length until a zero-coupon bonds maturity date the less the investor generally has to pay for it. Zero coupon bonds with a maturity of less than a year offer a short-term investment option.  

Tax on Gains: How is Income from these Bonds Treated?

As mentioned above, investors of notified zero coupon bonds issued by NABARD and REC are liable to pay only capital gains tax on maturity. Capital appreciation, in such cases, is the difference between the maturity price and the purchase price of the bond. In the case of non-notified zero coupon bonds, the difference between maturity and purchase price is treated as interest and taxed accordingly. 

Like the growth market, the fixed-income security market should be approached with a clear understanding of your investment goals and horizon. Zero-coupon bonds can work wonders if used meticulously and in sync with your investment objectives. 

Note: Apart from NABARD, only a few Government Organizations with approval from the Finance Ministry are authorized to issue zero-coupon bonds.

Approvals require annual revalidation if not utilized during the notification year. For more investment-related queries on zero coupon bonds, reach out to our experienced finance professionals at ClearTax today.